The invention relates to the field of financial risk management, particularly to evaluation and selection of investment portfolio asset allocations and other policies for defined benefit pension and retirement plans relative to the pension/retirement plans' liabilities.
Defined benefit pension funds in the corporate and public sectors promise specified amounts of benefits to participants upon reaching allowed retirement ages, as well as satisfying minimum service requirements. The promised benefit generally depends on the age at retirement, years of service, and may also depend on the participant's compensation over a specified period of employment. The financial obligation of the pension fund may be deferred for an extended period of time before actual payments are made; at the extreme, a new 20-year old participant may wait 45 years before receiving any pension payments from the fund. To avoid excessive cash requirements when benefits become due in the future and to take advantage of tax incentives available in the tax code for corporate plans, plan sponsors pre-fund the obligation, resulting in significant asset pools that need to be invested appropriately.
In the process of managing pension plan assets, plan trustees, investment committee members and investment consultants make recommendations and decisions regarding issues such as the fund's asset allocation, overlay investment strategies, choice of investment managers, the timing of such decisions. Academic studies (Brinson, et. al., 1986, 1991) have shown asset allocation explaining over 90% of the variation of pension plan returns. At its basic level, an asset allocation labeled as 60/40 indicates that 60% of the pension assets are invested in equity or equity-like investments, while the remaining 40% of assets are invested in bonds or bonds-like securities. However, it is common to refine the 60% equity allocation to more detailed sub-allocations; for example, the 60% may be further partitioned into 40% US Large Cap equities, 10% US Small Cap equities and 10% International equities. A similar refinement is generally done for the bond allocation (40% in the prior example) among bond sub-allocations.
The asset allocation policy is arguably the most important decision in managing pension fund assets. The process of setting a pension fund allocation generally involves the comparison of the existing policy with a number of candidate asset allocations. There is a wide variety of processes in coming up with these alternative asset allocations. One approach relating to the basic level described in the previous paragraph involves permutations of the 60/40 ratio. That is, an alternative portfolio may be generated by specifying a 50/50 target; this is done by allocating 50% of the assets to equities and the remaining 50% to bonds. Another approach is to select candidates from calculated efficient frontiers, using the optimization process pioneered by Markowitz (1952). This approach is generally applied to the approach where sub-allocations to equity and bonds are used. The optimization takes the form of allocating funds or portfolio weights to a number of asset classes, with the objective of maximizing reward for a fixed risk level, or minimizing risk for a fixed reward level.
In addition to allocating to various asset classes, the investment committee can also take advantage of a myriad of investment strategies that may be overlaid on the asset class choices. For example, active management rather than passive management and alpha transport may be implemented over a portion of the funds. Moreover, investment overlays may also be used on pension liabilities, such as interest rate swaps and futures to manage interest rate risk.
In addition to setting investment policies and strategies, plan sponsors also make decisions on additional defined benefit plan policies. Additional policies that require consideration are pension plan employer contribution funding policy, pension plan benefit policy, and actuarial methods and assumptions policy.
In selecting an asset allocation, overlay investment strategies and other pension plan policies, individuals responsible for the decision compare several financial measures involving risk and return for each of the allocations, strategies and alternative policies under consideration. For evaluating investment reward, frequently used measures are the expected investment returns over single and multiple years. Generally, the investment return is supplemented by additional metrics, such as expectations with respect to required pension plan contributions, accounting expense, dollar surplus, funded ratio. These additional measures are calculated relative to a variety of pension liabilities used by actuaries. For evaluating risk, measures include standard deviation, variance, downside risk measures (Harlow, 1991), specific percentiles of the statistical distribution of the metric (for example, 5th or 95th percentile). A third set of asset allocation comparative metrics are derived by taking the ratio of the reward measures over their corresponding risk measures, deriving efficiency measures. The above measures can be calculated over one and multiple years.
Other parties of interest such as stock, sector or industry analysts in the investment field evaluate risk of pension plans of publicly-traded companies that they cover, due to the increasing impact of the pension fund on the financial well-being of the enterprise. In Dec. 2003, the Financial Accounting Standard Board (FASB) revised Financial Accounting Standard 132 (“Employers' Disclosures About Pensions and Other Post-Retirement Benefits”). A new requirement was the disclosure of the pension plans' asset allocation policy. Another party that monitors pension risk would be pension regulators such as the Pension Benefit Guaranty Corporation (PBGC) which is responsible for guaranteeing pension payments in the US private sector. A similar agency in the United Kingdom (UK) would be the UK Pension Protection Fund. Rating agencies following the financial health of states, cities and municipalities also follow closely the pension funds in the public sector.
An increasing number of corporate and state defined benefit plans are currently in difficult underfunded situations; the situation was initiated by the so-called “pension perfect storm” of 2000-2002, where equity markets earned negative returns, while long yields declined to historical lows, thereby depressing discount rates and raising pension liabilities. The problems persist today, leading many plans to close to new entrants, as well as freeze existing benefits for ongoing participants. Plan sponsors are hoping that such moves will alleviate the level and volatility of required cash contributions as well as pension accounting expense. Moreover, in 2006, expected pension funding reform from Congress and pension accounting changes from the FASB are expected to exert even more pressure on plan sponsors.
Even though there is still considerable debate on whether there are excessive allocations to equities in pension asset portfolios, it is clear that the potential adverse impact of equity volatility on pension funds was unexpected and greatly underestimated, especially after the equity bull market of the 1990's. Unfortunately, plan sponsors have only belatedly realized that it is pension surplus or deficit that matters, not asset levels or return alone. However, even though plan sponsors are taking steps to ease the volatility as described in the prior paragraph, the existing pension liabilities are still very much significant and will require continued risk management over the next decades. The ability of plan sponsors to precisely understand investment consequences on pension surplus will largely drive investment and other pension policy decisions and the consequent financial condition of the pension plan, and the plan sponsor enterprise as well.
As describe above, the current method of constructing portfolio candidates involves the assignment of pension assets to asset classes; that is, for example, given a pension plan with $1,000 million in assets, the plan sponsor can assign $700 million or 70% of assets to the equity bucket asset class, and the remaining $300 M or 30% to bonds bucket asset class. Optimization routines also follow this process in the process of searching for the optimal allocation. Thus, the term: asset allocation. Clearly, the assignment of assets in this process did not involve the pension liabilities. Only during the stage of comparing metrics of candidate portfolios, overlay strategies and alternative policies did pension liabilities hopefully enter, through the measures involving pension funded ratios, contributions and accounting expense. The process, in some respect, suffers from the proverbial adage of “putting the cart before the horse”.